Forex Investment and Currency Trading

It certainly was a big week for headlines. Fed Chairman Bernanke has been the most persistently vocal with an aggressive campaign under way to reassure markets of the Fed’s focus on inflation risks and to limit any damaging increase in inflation expectations. The process began last Tuesday (3 June) with comments that specifically linked the fall in the USD and resultant rise in import prices as a threat
to inflation prospects, a comment that currency markets took to signal an effort to “talk up” the USD. While the USD continued its fledgling rally on the comment, it is continued to believe that currency markets are reading more into the statement about the USD than is warranted.

First, it is the US Treasury – rather than the Federal Reserve – that sets USD policy, and there is little to suggest that the Treasury is undertaking a campaign to “talk up” the USD. To the contrary, in his upcoming dialogue with Chinese leaders (scheduled for June 17-18 in Annapolis), Secretary Paulson is expected to continue to press the Chinese for faster CNY appreciation versus the USD, a position that
could be compromised by talk of a broadly stronger USD. Second, more recent anti-inflation commentary from Chairman Bernanke has shied away from comments about the USD and import costs, shifting the discussion to a more generic focus on inflation risks and the admission that the
impact of a widening output gap on dampening inflation appears less robust than in the past.

In this context, the Chairman’s comments have become more oriented towards the general inflation process and less oriented toward the USD, and markets have begun to discount rather aggressive Fed tightening during the year ahead. The June ’09 Fed funds futures contract yield has surged to 3.29%, up from a cycle low of 1.64% on March 17, and suggesting almost 150bp of Fed tightening by mid-2009. While additional Fed easing appears increasingly unlikely, the expectation for such aggressive Fed tightening over the next year appears equally unlikely, particularly given the sharp jump in the unemployment rate reported last week and ongoing strains in the US financial system. Indeed, recent Fed comments on inflation risks may have as much to do with setting the foundation for resisting calls for rate cuts in an election year plagued by a rising unemployment rate than actually signaling the prospect of rate hikes later this year.

Given the market’s expectation that Chairman Bernanke might be signaling a shift toward more activist USD policy, it is probably not surprising how aggressively markets reacted to Treasury Secretary Paulson’s response that he would not “rule out” intervention to support the USD. Put forth as an independent comment by Secretary Paulson, we might be more inclined to assign it significance. However, the comment was in direct response to a question inquiring whether the Secretary would “rule out” intervention. Like any good policy-maker, the Secretary indicated he would not rule in or out any particular policy action, maintaining a maximum degree of flexibility with respect to the use of all policy initiatives. And his continued focus on the “strong long-term fundamentals” continues to suggest that Treasury remains somewhat concerned about the short-term fundamentals, particularly the impact of the 30+% rise in gasoline prices versus last year. Should the G8 Finance Ministers meeting this weekend not lead to a meaningful change in the statement on FX rates, markets are likely to conclude that their response to recent rhetoric on the USD has been overdone, leaving near-term downside for the USD. And from a technical perspective, a failure of the USD Index (DXY) to close above trend-line resistance, currently at 73.76, would suggests near-term USD upside appears limited.